In 1918, Schumpeter (1991:101) wrote that âpublic finances are one of the best starting points for an investigation of society, especially although not exclusively of its political life.â His observation has generated a substantial body of literature on public finances, specifically taxation. Various scholars have highlighted that a broader tax base is essential for a nationâs economic development (Besley and Persson 2013; Bird 2013; Gaspar et al. 2016) and the development of the state itself (Levi 1988; BrĂ€utigam et al. 2008). Some have argued for a nexus between a countryâs democratic and institutional performance and a wider tax base (Prichard 2015). At the same time, informality remains a prevalent and persistent issue in most developing countries, where numerous market participants avoid formal registration with the authorities and evade tax payments. Williams (2014) has shown that informal employment accounts for around one-third of the global non-agricultural workforce, and Schneider et al. (2010) estimate the informal economy to amount to around 40% in Latin America, Sub-Saharan Africa, and Central Asia. With a specific focus on Paraguay, this book explores how taxation regimes can be used to formalise the informal market.
Literature and Context
The existing literature demonstrates that integrating informal market participants into the tax-net can lead to beneficial effects. For the formalised, such effects include growth possibilities, access to credit, increasing legitimacy, opportunities to expand the customer base, and access to contract enforceability (Perry et al. 2007; Joshi et al. 2012). States will exhibit fiscal implications as the tax base widens and the tax morale in general improves (Schneider and Torgler 2007; Gaspar et al. 2016). An additional body of literature argues that incorporating more citizens into the tax-net could lead to political change, including increasing the accountability and responsiveness of state institutions in the long term (Prichard 2015). Taxpayers appear to alter their behaviour when faced with an enhanced fiscal imperative (Moore 2008). However, relatively little research has provided micro-level evidence illustrating the taxpayerâs response in such a situation. The existing literature also fails to acknowledge the potential of developing a tax regime that systematically nudges customers to demand formalisation. Scholars have documented different fiscal and administrative approaches that authorities in developing countries adopt to foster the formalisation process and tax informal actors. Such approaches range from taxing the informal sector indirectly, strengthening enforcement and compliance, using presumptive tax regimes, simplifying and cheapening formalisation procedures, to administrative reforms that systematically incorporate informal actors into the tax-net (Joshi et al. 2012). These approaches show some merit in achieving their objectives, but their success mostly relies on the capacity of the tax authorities.
Paraguay offers fascinating insights for the literature. It is one of the largest informal economies in Latin America. Informal output accumulates to around 40% of total output (Vargas 2015) and over 70% of the labour force is estimated to be informal (ILO 2014). Moreover, businesses list informal competition as one of their greatest obstacles (World Bank 2018). Following two distinct tax reforms in 2004 and 2012, different measures suggest a formalisation process. After defaulting on domestic and foreign debt in the early 2000s, the Paraguayan government passed a comprehensive tax reform in 2004, which made significant alterations to the countryâs tax regime. Among other changes, the tax reform drastically cut the corporate income tax (CIT) rate, made most products subject to a 10% value-added tax (VAT) rate, and modernised and improved administrative procedures, which simplified firmsâ formalisation processes (World Bank 2013). The reform also introduced Paraguayâs first personal income tax (PIT), which, in turn, incorporated an innovative formalisation mechanism to the tax regime (ibid.). However, due to severe opposition from certain interest groups, the implementation of the PIT was suspended until 2012. The reforms resulted in improvements in revenue collections despite lower rates, as the tax base widened and compliance improved (ICT 2015). The number of officially registered firms rose sharply, more economic transactions are officially documented, and the VAT Gross Compliance Ratio1 improved significantly (SET 2017; Pecho and Jorratt 2016).
Objectives and Methods
The objectives of this book are twofold. Firstly, it seeks to better understand Paraguayâs formalisation approach. This will be achieved by outlining the policy drafting and implementation process and illustrating how the 2004 and 2012 tax reforms facilitate a formalisation process of the economy. Secondly, this book explores potential alterations of the taxpayerâs behaviour that might indicate a political response to the stateâs enhanced fiscal imperative.
The research is based on over 60 semi-structured, open-ended interviews with economic and political actors and experts, conducted in Paraguay between July and September 2017. The economic actors interviewed represent enterprises of varying sizes and with different levels of formality and were mostly located in the main commercial areas of Asuncion, Paraguayâs capital, and its surroundings. Some had acquired business licences from the municipality, however failed to register with the tax authorities. Others, while being registered and contributing taxes to the state, decrease their reliabilities through double bookkeeping. A final group stated that they operate in line with all requirements. Internal consistency and external validity of the collected data are ensured through a triangulation process of both obtained narratives and secondary sources of quantitative and qualitative nature.
Findings
The book illustrates that the CIT-rate deduction and the administrative improvements made it significantly easier and cheaper to formalise and to comply with regulations. This initiated a formalisation process. This research finds that the introduction of the PIT in 2012, which introduced an innovative incentive mechanism that motivates the demand for legally documented transactions, had the strongest formalisation effect. The Paraguayan income tax regime allows the taxpayer to deduct nearly all legally documented private and household expenditures. Therefore, the tax is only applied to unconsumed income and, crucially, to informally purchased goods and services. This distinct feature of the tax alters the behaviour of market participants. The tax punishes informal businesses as increasing numbers of customers demand formal documentation. Those market participants that formalise, in turn, can cater to all customers. Not surprisingly, a significant increase in officially documented market transactions is evident, and informal market participants formalise precisely for this reason. In short, while the alterations made in 2004 eased firmsâ compliance costs, with the implementation of the 2012 reform Paraguay managed to establish a tax regime that systematically incentivised the formalisation process of the informal sector through nudging customers and firms to formalise their transactions.
At the same time, distinct changes in the financial sector encouraged formalisation. Increasingly, Paraguayâs banks started to cater to smaller firms, while stricter banking regulations required businesses to disclose ever more transactions to the authorities. However, not all firms register and formalise their transactions. Double bookkeeping remains an attractive strategy to decrease tax burdens and informal firms cooperate with formal ones to circumvent the demand for official invoices. In certain sectors or locations, owing to the severe informal competition, the high level of informality makes it impossible to formalise. Moreover, this book demonstrates how certain interest groups, predominantly business elites, successfully managed to pressure for alterations of the reforms, specifically of the PIT. This showcases that Paraguay remains an elite captured society.
In accordance with the literature on potential political changes due to an enhanced fiscal imperative, the find...